Despite thinking often about our finances, the system of money in our country is not something that most people really stop to think about. You get your wages, spend what you want to spend and save what you want to save. But how exactly did our current system of money come to be? Our entire way of life relies so heavily on its availability and its value, yet the people that control its production, issue and usage are a small number of powerful individuals. In this series I attempt to explain the dire need for our country to democratise the management of our currency and how, when it comes to the future management of our monetary system, the whole world could benefit from a little bit more open-mindedness.
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Gold has traditionally been the world’s currency of choice. It is durable, divisible, relatively scarce and homogeneous (meaning that gold is gold, unlike diamond for example, where its value depends on the quality of the stone). History has also seen the rise and fall of numerous paper money systems, initially in China, which saw the dissolution of whole ruling dynasties in the 13th and 14th centuries, and several times in the west, mainly as a means for the state to fund war, such as the American colonial wars against the British Empire and Quebec, and across Europe in the Napoleonic wars. In all cases, a gold standard was returned. With a gold standard, people used to be able to go to the bank and redeem their money for a fixed value in gold. Nowadays you can’t. The amount of gold you can buy with your money varies.
The UK officially left the gold bullion standard in 1931, which initially benefited the country, as it allowed us to use ‘loose monetary policy’ to create growth in the economy. (This generally means printing money and lowering interest rates to make credit more easily obtainable.)
In 1944, the leaders of the western economies agreed to peg their currencies, with varying degrees, to the US dollar, which was to become the new world reserve currency. This was known as the Bretton Woods treaty, after the location in the US where the international summit was held. The allied European nations were all indebted to the United States after WWII and economists saw it as crucial that there would not be a return to previous periods of trade protectionism whereby individual nations would restrict imports in certain industries through tariffs and other trade barriers in order to protect domestic producers. The nations shared the common faith in capitalism and the belief that with freer trade and a more stable monetary and exchange rate system, all nations could develop together and the world could prosper. The US agreed to back the dollar with gold at $35 an ounce, so it was, in effect, similar to a return to the gold standard, only with the US dollar as the new currency of choice.
In 1971, the US terminated the dollar’s convertibility into gold, thereby ending the Bretton Woods system and turning the US dollar, and effectively the other currencies pegged to it, into a fiat currency. This meant that it was no longer backed by a gold standard but instead solely by the promise of the United States government. Therefore, from the year 1971, the western governments had no real restraining force to stop them from printing more money. We had essentially begun to use yet another paper currency, just like all the other paper currencies that mankind has invented, abused and destroyed. I guess this time around people thought it would be different.
Money follows the same laws of supply and demand that all products must obey. As with any commodity, if there is an abundance of it, it is cheap; if it is scarce, then it is expensive. As the supply increases, the price falls. The supply of Pounds Sterling has been increasing dramatically since 1971. The price (the value) has therefore been falling. Whereas there were around 30billion pounds in circulation in 1971, there are over 50 times as many today. The pound is worth nothing what it was worth back then. If you'd have gone to the supermarket in 1971 and spent £5, you would have been able to take home an enormous volume of goods, something between £50-100 of shopping in today’s terms.
So, our money (our salaries and our savings), is being devalued because the money supply is increasing. As the government prints more and more money, everyone loses money. Well, technically we don’t lose money, but we lose the value of our money. The government prints more money, which in turn devalues all of the money in circulation and makes us all poorer. This is called inflation. Inflation = people getting poorer.1
So, our money (our salaries and our savings), is being devalued because the money supply is increasing. As the government prints more and more money, everyone loses money. Well, technically we don’t lose money, but we lose the value of our money. The government prints more money, which in turn devalues all of the money in circulation and makes us all poorer. This is called inflation. Inflation = people getting poorer.1
So how do we stop inflation? The answer is remarkably simple: stop printing money. The real question is: How do we get the government to stop printing money? I will suggest answers to this question later on in this series. Firstly, let’s look at why the government prints money in the first place.
The most common reasons that the Bank of England gives to the public in the press, are a) “Stimulus” – This is the word favoured by politicians to support ‘demand side’ economic policies such as ‘quantitative easing’ (creating money). It is based on the assumption that the lack of growth in the economy is due to a lack of demand. In other words, people are being too cautious and not spending enough money, so by giving people more money, they will then demand more, spend more and “stimulate” the economy. Instead of physically printing notes or minting coins, the Bank of England buys assets from the banks, using ‘electronic’ money created out of thin air, so that the banks might lend the proceeds to businesses, who in turn will use the money to invest and employ more people, who will in turn spend their wages etc and therefore cause economic growth. b) To prevent “deflation” – This is the theory that in these uncertain economic times, due to people’s unwillingness to lend and spend money, the money supply will shrink naturally, i.e. people will hoard their money in order to spend and invest at a later date instead of taking a risk now when the economy is bad. The fear is that this in turn will cause retailers to lower the prices of their goods in desperation to sell something, which in turn causes them to cut their costs and investment, which in turn means less jobs, less spending and more price cutting etc etc. This is called a deflationary spiral. The motive to print money therefore, is to increase the money supply in anticipation of recession, in order to combat the credit crunch before it hits hard. In other words, use inflation to counteract deflation.
Both of these reasons, ‘stimulus’ and ‘preventing deflation’, are theoretically sound, but on closer inspection they rely on a number of assumptions that are wholly unsubstantiated. Firstly, it is assumed that the benefits outweigh the costs, i.e. the future problems associated with inflation and rising prices are overshadowed by the short term stimulus in demand brought on by expanding the money supply. However, the argument that the economic slowdown causes deflation is, at best, only a temporary reality. The real money supply doesn’t really shrink all that much; not everyone takes their money out of the bank and stashes it under their mattress. It is that people’s willingness to spend decreases (something that economists call the velocity of money). Money not being spent will eventually be put to use at some point in the future and unless the Bank of England changes its policy, the inflationary effects will soon be felt. Of course, retailers can put up their prices whenever they want, and merely the news that the government has created money out of thin air will tempt them to do just that. The demand that this policy is designed to “stimulate” may well be quickly stifled by the price increases that follow. People want to spend money when things are cheap, not when they are getting more expensive.
More importantly, from a broader perspective, it assumes that the problem is a ‘demand side issue,’ meaning that the root of the problem is the lack of demand in the economy. Pumping money into the economy will undoubtedly ‘stimulate’ demand, but people cannot be controlled. What if people don’t want to spend money because they are genuinely apprehensive of the impending doom and gloom that has been built up over the past few years. No matter how much money you create, people just don’t want to spend, and companies just don’t want to invest, at least not yet, not until conditions improve. The assumption that by giving money to the banks, that this money will then trickle down the economy and eventually find its way into the hands of small businesses and consumers, could turn out to be entirely false. It is quite possible that this money goes no further than the banks, who, despite the ‘easy money,’ are themselves still unwilling to lend to businesses due to the underlying grim economic outlook.
The reasons for creating money given by the government are largely unconvincing. The supposed advantages are at best speculative, whereas the disadvantages are plain and simple. The government’s defence of these policies is wearing thin. However, in conjunction with the media, the government has been always able to spin the reported motives of these policies to appear just and noble, and in the ‘national interest’, when they are of course fully aware of the long term destructiveness of the pursuit of such a policy. They tell us that the high inflation rate is not due to government policy but instead due to a range of macroeconomic factors beyond our control, driving up the price of oil, gas and other commodities, which affect energy prices as a whole, which in turn have knock on effects to the other goods that consumers purchase. These factors inevitably play their part, but have become a familiar excuse for the government to obscure the impact of their monetary policies. It is time they admitted that their policies of money creation and cheap credit are also significant driving forces behind rising inflation.
So do governments really believe that creating money is in the country’s national interest? Or do they have other motives? In the next post I will talk about possible other motives to print money, other than the reasons the government and Bank of England officials give to the newspapers. One thing is for sure, at the rate which the government is creating money, the mighty Pound Sterling is looking more and more like Monopoly money - colourful, plentiful and worthless.
Read on » Monopoly Money part 2
1In actual fact, economists argue that a small rate of inflation is required in periods of economic growth to provide the money in the economy to support the increase in business activity. The Bank of England estimates this ‘acceptable’ or ‘target’ rate of inflation to be around 2%, but current figures show inflation to be at well above 5%. At this level, the phrase: inflation = people getting poorer, is not an inaccurate generalisation.
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